Vocabulary Assumptions: Ideas that are accepted as accurate without proof. Households: The sector consists of just people—private individuals or families. Firms: Organisations that produce goods and services. Government sector: The part of the economy consists of state-owned institutions collecting and spending tax revenue. Financial sector: The part of the economy that includes banks, investment funds, and other financial services firms. Foreign sector: the economic transactions of the economy with the rest of the world, e.g. how resources flow between Australia and its trading partners Leakages: Money flows from the household sector that reduces their subsequent spending on the production of domestic-based firms. Tax: An involuntary contribution to government revenue levied on individuals or firms, often concerning incomes, profits or the sale of goods and services. Savings: The portion of disposable income not spent on the consumption of goods and services. Imports: Goods and services purchased from other countries. Injections: Additional spending that flows to firms and, therefore, to the circular flow of income within the economy. Government spending: Money spent by all levels of government, including government consumption and investment spending. Investment: Any spending that increases the economy's capital stock, including firms spending on new equipment or households' spending on new homes. Exports: Goods and services sold to other countries. The basic circular flow model depicts how money is exchanged for resources and products in an economy. This basic model assumes only two groups/sectors in the economy: 'households' and 'firms'. Money flows from households to firms and back again. Households buy goods and services and provide firms with resources, such as labour or capital. Firms produce goods and services and sell them to households. The circular flow model is sometimes called the 'circular flow of income' model because it shows where various economic sectors obtain income. Pinned note icon Notes Economic models usually contain assumptions. We have to make assumptions to simplify the model because real life is much more complicated. The above basic circular flow model assumes only two sectors: households and firms. It also assumes households own and control all resources and spends their money only on goods and services. This is not exactly how it works, but the model still provides a useful overview of how money moves around the economy. Activity Icon The five-sector circular flow model The five-sector circular flow model is more realistic than the two-sector model but still contains assumptions and is more simplified than reality. The five-sector model recognises the important roles that government, financial institutions and other countries play in an economy. Let's look at how money flows from households to sectors other than firms. Households don't just spend all of their income on buying goods and services. They must also pay taxes, save money, or buy products (imports) from other countries. These flows of money represent money flowing away from that basic circular flow of income in the two-sector model, so we refer to them as leakages. Activity Icon What do governments, financial institutions and foreigners do with the money they receive? The government uses tax revenue to provide public services. Often, this involves funding firms that can produce and supply these services. Government-funded products may come from private firms or government-operated organisations. Examples include schools, roads, and healthcare. In reality, the financial system in an economy is very complicated. However, our model assumes money flows from banks to firms because firms borrow to spend on investments. An example of investment spending is firms paying other firms for capital equipment or resources. Finally, money can flow back into the domestic economy's circular flow or income when the foreign sector (overseas households and firms) spends money on exports, goods and services produced by the firms in this economy. This export spending becomes income for firms. These three flows of money are called injections. This is because they represent money being injected back into that original basic circular flow of income between households and firms. Pinned note icon Notes Injections are 'positive' influences on economic growth—they add to the value of real gross domestic product (GDP). In contrast, leakages can have a negative impact on economic growth as they may reduce some components of GDP. Vocabulary Gross domestic product (GDP): the market value of all final goods and services produced within a country in a given period of time. In simpler terms, it measures the total value of the output produced by an economy. Real GDP Real gross domestic product (GDP) The market value of all final goods and services produced in an economy during a period of time, adjusted for inflation. Nominal gross domestic product (GDP) The market value of all final goods and services produced in an economy during a period of time, measured in today's prices. Intermediate goods: Goods used as inputs for the production of final products. Final goods: Finished goods produced for the ultimate, final user. Activity Icon What is GDP? We often judge whether a person is doing well economically or not based on his or her income level. A higher income level suggests that the person can enjoy a higher standard of living, spending on better housing, healthcare, education, and luxuries like fancier cars and more vacations overseas. Similarly, we can judge whether an overall economy is doing well based on the total income that its people are earning. This is measured by Gross Domestic Product (GDP). Growth in GDP suggests that the economy is growing, allowing everyone in the economy to consume more goods and services and enjoy better living conditions. Recall that one of the key macroeconomic goals of an economy is economic prosperity, which is a situation whereby a nation and its people are experiencing high living standards over the long term in a sustainable way. Since growth in GDP is typically used as the measure of economic growth, let's have a closer look at what GDP means. Some of the GDP measures that are reported on in an economy are: Real GDP (refer to the vocab) Nominal GDP (refer to the vocab) Most economists believe that Real GDP is the better measure as it removes changes in prices over time. However, both measures are reported because economies are interested in measuring whether domestic production has grown over time, independent of market prices. For this reason, economists generally report both nominal GDP and real GDP. In the next few lessons, you will learn about the business cycle and AD/AS models, which will use real GDP to help explain the economy. It is important for you to understand the difference. Activity Icon GDP definition explained Let's consider each phrase separately to better understand what the definition means. Gross domestic product: the market value of all final goods and services produced within a country in a given period of time. In simpler terms, it measures the total value of the output produced by an economy. The following items are not included in GDP: Second-hand goods (these have already been counted when first produced and sold!) Intermediate goods (these form part of a final product) Transfer payments such as unemployment benefits, pensions, etc (these payments do not represent any production taking place. Activity Icon How is GDP calculated? Now that we better understand what GDP measures, we need to consider how the government calculates GDP. One method is using the expenditure approach, which involves adding all the spending on domestically produced final products during a specific period of time. All domestic production is typically purchased in four categories: households, businesses, the government, and foreigners. Hence, GDP (Y) is divided into four components: consumption (C), investment (I), government spending (G) and net exports (exports - imports (X-M)). Pinned note icon Notes Y = C + I + G + (X - M) Activity Icon An example of GDP For example, if in Mufyland in 2024: Household consumption was $800 billion, Investment expenditure by firms was $350 billion, Government expenditure was $400 billion, Exports amounted to $200 billion, and imports totalled $250 billion, GDP (in billions of dollars) would be equal to: Y = 800 + 350 + 400 + (200 - 250) = 1500 Let's look at each of the four components more closely: Consumption (C) This is the total spending by individuals or households on goods and services produced in the economy. This category includes expenditure on both tangible and intangible items produced such as food, clothing, cars, healthcare and haircuts. Investment (I) Investment includes any spending that increases the economy’s capital stock, such as firms’ expenditures on new equipment. Essentially, investment refers to spending on goods that will be used to produce other goods and services in the future. Additionally, any output added to inventory but not sold during the period is considered “purchased” by the company and is part of the firm’s investment. Households’ spending on new homes is also classified as investment. This component is often called ‘private investment’ to distinguish it from government investment spending. Government spending (G) This refers to money spent by all levels of government, including government consumption and investment spending. It includes salaries of government employees such as the national defence, teachers, and health workers, as well as spending on highways, bridges, and government buildings. However, remember that this component excludes transfer payments such as pensions and unemployment benefits paid by the government, as they do not represent currently produced output. Net exports (X - M) Is the spending on domestically produced goods by foreigners (exports) minus purchases of foreign goods by domestic residents (imports). The reason why spending on exports by foreigners needs to be added while expenditure on imports needs to be deducted is that when the government collects data on the other three components (C, I and G), the data includes spending on foreign products as well, but excludes domestic products purchased by foreigners. Since GDP is only a measure of domestic production, exports must be added to GDP while imports need to be deducted. The business cycle refers to alternating periods of economic growth and contraction over time. Changes to other key economic measures, such as sales, consumption, production, and employment, also accompany changes in real GDP. Downturn: A phase in the business cycle characterised by decreasing levels of economic activity or decreasing rates of growth. Recession: A severe prolonged downturn in the economy, often measured in terms of two quarters (six months) of negative economic growth. Upturn: A phase in the business cycle characterised by increasing levels of economic activity or an increasing rate of economic growth. Peak: A phase in the business cycle where economic activity has reached a maximum and is at a turning point towards a decline. Trough: A phase in the business cycle where economic activity has reached a minimum and is at a turning point towards improvement. Vocabulary Aggregate demand (AD) refers to the total demand for all final goods and services that households, firms, the government and foreigners want to purchase at a given price level. Economists use the model of aggregate demand and aggregate supply to explain the short-run fluctuations in real gross domestic product (GDP), which we call the business cycle. Aggregate demand (AD) refers to the total demand for all final goods and services that households, firms, the government and foreigners want to purchase at a given price level. This concept differs from the simple market demand and supply you learned in microeconomics. In microeconomics, you would have looked at the demand in a particular market, e.g. ice cream. In contrast, in this topic, we are concerned with the demand for the total output produced in all of the economy's markets. Aggregate Demand is calculated using the following formula Aggregate demand consists of four components: consumption demand (C), investment demand (I), government demand (G) and net export demand (X - M). AD = C + I + G + (X - M) Please note: In the above formula, X refers to 'export demand', and M refers to 'import demand'. You may recall that this is the same way we defined GDP. The difference is that GDP refers to the quantity of spending that occurs in the economy in a given period of time. In contrast, AD is a function that relates the quantity of spending to the price level and thus can be shown as a curve showing possible spending that might take place at varying price levels. An analogy can be drawn with microeconomics, where the concept of 'demand' differs from 'quantity demanded'. Demand refers to all the possible quantities of a product purchased at each possible price, whereas the actual quantity demanded is a single number. It is the same with AD and GDP: AD shows all the possibilities, whereas GDP is an exact quantity of goods and services measured in dollar values. Pinned note icon Notes Although we are using the same categories for GDP, the total aggregate demand by households (C), businesses (I), government agencies (G), and foreigners (X—M) may not necessarily equal the amount firms want to sell. The quantity demanded by households, firms, the government, and foreigners will depend on a range of factors, such as their needs, expectations about the future, and the cost of borrowing. Vocabulary Purchasing power: The extent to which a person's money can buy goods and services. Wealth effect: An effect whereby a rise in the price level impacts the purchasing power of people's wealth, causing them to demand less goods and services. Net exports effect: An effect whereby a rise in the price level relative to the price level in other countries has a negative effect on the quantity of net export demand. Just like a market demand curve, the AD curve is downward sloping. However, the reasons for the downward slope are not the same as why a market demand curve is downward sloping. An individual person's demand curve (and therefore a market demand curve) is downward sloping partly because of a 'substitution effect' - whereby as one product becomes more expensive, consumers will switch to another similar product and thus demand less of the first product. AD is measured against the average price level of all products, so there cannot be a substitution effect - a rise in the price level theoretically means all prices have increased. There are several reasons why AD is downward sloping. Only two will be explained here: Wealth Effect Net Export Effect Activity Icon What could cause the Aggregate Demand curve to shift? A shift in AD occurs when the quantity of AD changes at each different possible price level. The whole AD curve moves leftward or rightward, as shown in Figure 2. Activity Icon Shifts of the Aggregate Demand Curve Shifts in the AD curve are caused by any factors that influence each AD component. In the following chapters, we will examine each of the four categories of demand. (Consumption, Investment, Government, and Net Export). Activity Icon Figure 1: Increase Aggregate Demand Curve Activity Icon Figure 2: Decrease Aggregate Demand Curve Factors causing the shift in Aggregate Demand Consumption Investment Government Net Export Demand Vocabulary Disposable Income: The amount of money households have left after taxes are accounted for. Consumer Confidence is an economic indicator that measures consumers' optimism about their economic situation and the economy in general. Business confidence An economic indicator that measures the degree of optimism business managers have about the current and future performance of the economy. Interest rates are the rates paid by financial institutions on deposits and other financial assets and charged on loans and other borrowing. Capacity utilisation is the percentage of an economy’s production capacity that is actually being used. It shows how much of the available resources—like factories, machinery, and labour—are actively producing goods and services. Inventories are the items a business keeps in stock to sell or use in production. Activity Icon Consumption Demand (C) Consumption demand (C) refers to the demand for goods and services by individuals or households in an economy. As outlined below, consumption demand is influenced by factors such as: Household disposable income (affected by taxation rates) Consumer confidence Household wealth Interest rates Expectations about future inflation rates Activity Icon Investment demand (I) Investment demand (I) refers to the private demand for spending on buildings, equipment and changes to inventories. As outlined below, investment demand is influenced by factors such as: Interest rates Business confidence Technological progress Capacity utilisation Taxation rates and government subsidies Activity Icon Government demand (G) Government demand (G) is the third component of AD and represents the government's demand for final goods and services produced in the economy. Government spending is generally considered an autonomous expenditure (independent of the economic activity level) based on political decisions. For example, a government whose objective is to stimulate the economy may decide to spend more on building infrastructure or researching new technologies to improve productivity. A government elected due to its promise to reduce government debt will decide to spend less. Government demand is independent of factors such as disposable income and interest rates in the economy. If, for example, the government decides to construct more highways, the quantity of goods and services demanded at any price level would rise, increasing AD and shifting the AD curve to the right. Government demand includes demand for both government consumption spending and government investment spending. Activity Icon Net Export demand (X-M) The fourth and final component, net export demand (X - M), is the total demand for an economy's exports minus the total demand for its imports. Net export demand is influenced by factors such as: tastes and preferences for an economy's goods and services relative incomes of an economy and its trading partners fluctuations in currency exchange rates Vocabulary Aggregate supply (AS) is the total quantity of goods and services that firms in an economy are willing to sell at a given price level during a given time period. The aggregate supply curve shows the quantity of production (real GDP) firms would be willing and able to supply at various different possible prices levels. A simple depiction of the aggregate supply curve is shown in Figure 1: Activity Icon Figure 1: The Basic Model of Aggregate Supply Pinned note icon Notes As you can see, there is assumed to be a positive relationship between quantity of aggregate supply (measured by real GDP) and the price level. Activity Icon Why is the AS curve upward-sloping? There are various theories about the shape of the AS curve, but it is generally agreed that it is upward-sloping in most situations. There are a few different ways to explain this, but a simple way to understand this is to assume that workers become less available as the quantity of production in an economy increases. Firms must pay higher wages to attract labour or pay their existing workers higher rates to work more hours to produce more. Let's consider that resources become scarcer as an economy produces more. It seems reasonable that firms will only be willing to supply more aggregate quantity if they can sell at higher prices. Since resources become scarcer as the total quantity supplied in an economy increases, firms may use less efficient or less suitable resources to meet higher production levels. Hence, they have to raise prices as they expand the quantity supplied. Activity Icon What factors might cause the aggregate supply curve to shift? Activity Icon Figure 2: An Increase in Aggregate Supply As shown in Figure 2, a rightward shift of the AS curve is referred to as an increase in AS. Activity Icon Figure 3: A Decrease in Aggregate Supply A leftward shift of the AS curve, shown in Figure 3, is referred to as a decrease in AS. Activity Icon Factors Affecting Supply Pinned note icon Notes Increases or decreases in AS are generally caused by factors that affect costs of production—higher costs of production cause AS to decrease, and lower costs of production cause AS to increase.Vocabulary Macroeconomic Equilibrium is a situation whereby the quantities of aggregate demand (AD) and aggregate supply (AS) in an economy are equal at a particular price level. Information Macroeconomic Equilibrium In an economy if the total quantity of goods and services demanded in an economy (aggregate demand) is greater than the total quantity of goods and services supplied in an economy (aggregate supply), we would expect firms to react by hiring more workers, demanding more resources, and producing more output (expanding their supply). Similarly, we would expect the price level to adjust. On the other hand, if aggregate demand was less than aggregate supply, we might expect firms to lay off workers or stop hiring to demand fewer resources and produce less. They may sell any inventories that exist rather than produce more. The equilibrium point, where, in theory, the aggregate quantity of goods and services demanded in an economy is equal to that supplied, is effectively the level of GDP produced (Y*). The price level (PL*) at which this occurs is shown on the vertical axis. Activity Icon Figure 1: The AD-AS Model Pinned note icon Notes We don't usually use numbers in our model—we use them to predict whether changes to AD and AS will negatively or positively affect the price level and real GDP. The following chapters show examples. Activity Icon How do changes to aggregate demand affect macroeconomic equilibrium? Shifts in aggregate supply or aggregate demand will cause changes to macroeconomic equilibrium. For instance, if aggregate demand increases, we expect upward pressure on the price level (inflation) and an increase in real GDP or economic growth, as shown below in Figure 2. (You can refer back to your learning on AD to be reminded of the factors that might cause changes in AD.) Activity Icon Figure 2: An Increase in Aggregate Demand If aggregate demand decreases, the opposite is true: we expect downward pressure on the price level (usually, this means lower levels of inflation, not necessarily a lower price level), as shown in Figure 3 below. Activity Icon Figure 3: A Decrease in Aggregate Demand Activity Icon How do changes to aggregate supply affect macroeconomic equilibrium? Any changes to aggregate supply will also affect macroeconomic equilibrium and, therefore, the price level and real GDP. If aggregate supply increases, the AD-AS model predicts that this would cause downward pressure on the price level while positively affecting real GDP, as shown in Figure 4. Activity Icon Figure 4: An Increase in Aggregate Supply You can refer back to your learning on aggregate supply to remember the factors that might cause changes in AS. A decrease in AS would have the opposite effect. The model predicts that a decrease in AS would lead to upward pressure on the price level and a negative effect on real GDP, as shown in Figure 5 below. Activity Icon Figure 5: A Decrease in Aggregate Supply Above is all the content I need to learn. Using only the material given above, give me 20 hard MCQ Questions